Question

Can I please get parts (d) (e) and (f) explained to me from Keown Text Chapter 9, Mini Case, in more detail of how to find the answers and why? I'm confused with how the numbers and percentages were found and I would like to better understand why cost of calculation to use and why?

d. Compute the weighted average cost of capital for Nealon’s investment using the weights reflected in the actual financing mix (that is, $20 million in retained earnings and

$50 million in bonds).

Cost of retained earnings = $2.5(1+.06) +.06

                                                [$35]

                                    = $2.65 +.06

                                        $35

                                    = .1357

                                    =13.57%

Source	Proportion	Cost of capital	WACC (new)
Retained earnings	28.57% ($20m)	13.57%	3.88%
Bonds	71.43% ($50m)	5.24%	3.74%
Total	100% ($70m)		7.62%

Compute the weighted average cost of capital for Nealon where the firm maintains its target capital structure by reducing its debt offering to 40 percent of the $70 million in new capital, or $28 million, using $20 million in retained earnings and raising $22 million through a new equity offering.

Source	Amount	Proportion	Cost of Capital	WACC
Bonds	$28 mil	40%	5.24%	2.1%
Retained earnings	$20 mil	27.57%	13.57%	3.88%
Equity	$22 mil	31.43%	14.03%	4.41%
Total	$70 mil	100%		10.38%

f. If you were the CFO for the company, would you prefer to use the calculation of the cost of capital in part (d) or (e) to evaluate the new project? Why?

If I were the CFO for Nealon Energy Corporation

Answer 1

f) Target capital structure should be used and not the current capital structure. The reason is that capital projects are to be assessed on the basis of marginal capital structure (that is the capital structure for the proposed project) and if there is a target capital structure, then on the basis of the target capital structure.

The target capital structure would be representative of the overall company and would be future oriented. In the event of existence of a target capital structure, it would be irrational to use marginal capital structure for each project, as order of priority would change the discount rate for the same project.

d) The formula used for finding cost of retained earnings is the constant dividend growth model.

According to the model, Cost of retained earnings = D0*(1+g)/P0 + g, where D0 is the last dividend paid, P0 is the current price and g is the growth rate. For theory on the formula please refer any standard text book.

e) Cost of equity (new shares) would have to consider floatation costs also. Hence, the above formula becomes, cost of equity = D0*(1+g)/(P0-floatation cost per share) + g. Please note that cost of new equity would be higher than the cost of retained earnings as the full market price is not realized; it will be reduced by the floatation cost.